Inflation or Deflation?

May 13th, 2009

Much confusion continues to reign as to whether the world’s financial system is suffering from inflation or deflation.Given the brilliance of some of the commentators on today’s financial woes, I would think that the issue should be settled, but it is not.

The classical definition of inflation is an increase in the money supply; deflation is the opposite: a decrease in the money supply.All other things being equal (They rarely are.), inflation (an increase in the money supply) results in an increase in the general price level, deflation (a decrease in the money supply) causes a fall in the general price level.

The confusion rises from the misappropriation of the use of words inflation and deflation by persons not familiar with the classical definitions.To most news commentators and writers, and, sadly, many members of the financial world, inflation has come to mean an increase in prices, deflation a fall in prices.

Even Richard Russell, whom I consider a brilliant stock market analyst, goes with a confused concept of deflation.He writes about deflation in the stock market and deflation in the housing market, referring to falling prices.But, as Gary North has explained in a several treatises on deflation/inflation, which can be found on www.lewrockwell.com, the terms are used to indicate what is happening to the money supply.Inflation and deflation are not words to indicate which direction prices are moving.

For example, the prices of computers have been falling for years.Computers that deliver increased capability are cheaper almost by the month (albeit the rate of decline is slowing.)Yet no one writes about deflation in the computer market.

I suspect that deflation crept into financial jargon because the stock market is a “money world.”It is where money is made and lost.And, during the housing mania, houses became investments.When I was a kid, a house was a home, a place where you lived, and something that most adults wanted to get debt free as soon as possible.(There was never any debt on the house in which I grew up, a concept that has probably as dead as the dodo.)

So, when stock prices fall over extend periods, financial analysts write about deflation in the stock market, and falling home prices elicit comments about deflation in the housing market.

Getting back to the macro-view, is the world’s financial system suffering from inflation or deflation?It depends on what you mean by the definitions of inflation and deflation.(Thank you, Billy Clinton.“It depends on what the meaning of the word is is.”)

If by inflation you mean an increase in the money supply, we are definitely suffering from inflation.Central banks around the world are cranking out their currencies, but none as massively our central bank, The Federal Reserve System.The world is awash in paper currencies, or, worse yet, digital dollars that reside silica chips in computers.

However, if you define deflation as falling prices and look at stock prices and house prices, we are suffering from deflation, or, at least, deflation in two very important segments of our financial world.

What does all this mean to investors who opt for gold investing, who buy silver?Should they buy more gold?Should they lighten their positions by selling gold?This topic will be revisited on this blog, but for me it is scary to have a lot of money sitting in banks, I do not care if we are seeing falling prices in some important sectors of our economy.

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